Problems cast long shadow

THE good news is that the global economic recovery continues to firm.

THE good news is that the global economic recovery continues to firm. The bad news is that the problems surrounding Greece and other southern European economies cast a long shadow.

Expectations for global economic growth and for corporate profits have been boosted by the robustness of key macroeconomic data releases during the first quarter of 2010, particularly in the US. Employment started to grow again in the US and there were signs of stability in the housing market.

Moreover, there was a vigorous jump in retail sales over the previous quarter, despite a continuing fall in the volume of consumer credit. Business and investor confidence has risen markedly.

But, as we have stressed in the past, the shape of the current recovery is, in no small measure, the result of past policy decisions. The US is a case in point. Monetary and fiscal policy has been particularly forcefully applied there. The IMF estimates that fiscal stimulus boosted real US GDP growth in 2009 by about 1 percentage point. But the impact of last year’s US fiscal package is expected to peak in 2010, with its effects starting to wane later this year.

So the question of how much to credit policy for the strength of the recovery – and, therefore, of how much the economy could suffer once it is withdrawn – is still a very open one.

In other parts of the world the legacy of the recent recession is more evident. The euro, and some European asset prices, remain at the mercy of fears about sovereign risk. Developments in Greece have also undermined the standing of some European institutions. The sheer size of the country’s fiscal challenges seems to preclude straightforward solutions, as is evidenced by the markets’ rather sceptical response to rescue plan announcements so far.

The Greek government has said that it wants to bring the current fiscal deficit of 13.6% of GDP in 2009 down to one of 5.6% next year.

Managing an adjustment of this scale would be challenging enough during a healthy economic expansion. But the Greek economy is weak and is expected to keep on contracting, with unemployment probably soaring in the next 18 months or so.

And, as the Argentinian case has shown, even when multilateral institutions and external investors agree with the government on a course of action, the pill can still be seen as too bitter by domestic audiences – thus unravelling plans that had initially looked feasible on paper. The interplay between domestic politics and budget cuts is a big unknown.

The chess game between market expectations and European policymakers may also have made matters worse. The hesitant reactions of EU leaders to the Greek crisis have encouraged market participants to think the unthinkable, in terms of a possible default.

The downgrading of Greek debt to junk status by Standard & Poor’s intensified market nerves, and contagion to other bond markets was spreading – even before the same agency’s more recent downgrading of Spanish debt last week. Fallout from the crisis could weigh on investor sentiment short-term, particularly as regards the euro.